A Unicorn Is Worth What Fidelity Says It's Worth
What interest rate should you use to discount those cash flows? Here’s accounting scholar Alfred Rappaport, writing in the 1981 Harvard Business Review article generally credited with introducing the phrase “shareholder value” to the world:
The appropriate rate for discounting the company’s cash flow stream is the weighted average of the costs of debt and equity capital.
There are significant exceptions, but most unicorns don’t have significant debt, which means that all we need to know is the cost of equity capital. Easy, right? Back to Rappaport, who was discussing the case of a hypothetical semiconductor maker -- the 1981 equivalent of the modern unicorn, usually defined as a startup with a valuation north of $1 billion:
Risk-free rate + average beta coefficient for selected similarly financed semiconductor companies × market risk premium for equity investments = cost of equity
Figuring out beta -- the volatility of an individual security relative to the market as whole -- for a company that isn’t publicly traded (another unicorn trait) is of course problematic. As Rappaport notes, though, you can make do with similar companies that are publicly traded. Meanwhile, finance professors have learned since 1981 that the market risk premium for equity investments isn't some sort of divinely decreed constant but a thing that grows and shrinks as investor attitudes change. And even the risk-free rate moves around a lot. So there are better ways of estimating the discount rate and worse ways, but there is no absolutely correct rate.
Then you have to estimate future cash flows, which is even more of a crapshoot, especially for companies that don’t even have positive cash flows yet, as is the case for most of the unicorns. Back in 1963, Princeton economics graduate student Burton G. Malkiel concluded, after examining a “growth stock” boom and bust in 1961 and 1962, that:
our analysis has at once demonstrated what an ephemeral process valuation is and underlined the very severe limitations by which any model of security valuation must necessarily be beset. There is no self-evident horizon for the projection of growth rates, only a putatively reasonable one. The history of share-price behavior demonstrates ineluctably that investors are at some times willing to take a much longer view than at others.
For Malkiel this was reason enough to throw in the towel and become a random walker and leading promoter of index funds. But what if you’re on the Fair Value Committee at Fidelity Investments, and you’re charged with putting a value on the non-public unicorns in Fidelity’s mutual fund portfolios?
The Fair Value Committee’s revaluations first made news last month, when journalists figured out that Fidelity had sharply marked down the value of its investments in Snapchat, Zenefits and other startups since spring. Now that everybody knows where to look, this is clearly going to be a monthly news event. Here’s Fortune’s Dan Primack, writing Monday about the latest Fidelity numbers, which are reported with a one-month lag:
Mobile messaging and media company Snapchat … saw Fidelity mark up the value of its Series F shares by 14.65% between the end of September and the end of October. It’s a strong bump, but still puts Fidelity in the red (again, on paper) by 14.43%. Shares in file-sharing and storage company Dropbox appreciated by 4.66% during the month, which puts them 45.8% over cost, but still nearly 16% below Fidelity’s carrying value at the end of May.
How did Fidelity’s Fair Value Committee arrive at these new numbers? Here’s Fidelity’s own description of the process, from the annual report of its Blue Chip Growth Fund, which has several unicorns in its portfolio:
When current market prices, quotations or currency exchange rates are not readily available or reliable, investments will be fair valued in good faith by the Committee, in accordance with procedures adopted by the Board. Factors used in determining fair value vary by investment type and may include market or investment specific events.
“Investment specific events” that would cause the committee to, say, revise its estimates of Snapchat’s and Dropbox’s future cash flows will happen occasionally, but surely not every month. Which leaves market events: outside observers seem to think that what Fidelity is mainly doing is looking at what’s happening to similar publicly traded stocks. For Snapchat, one of those stocks has got to be Twitter’s, which has had a terrible year but a pretty good October (up 5.6 percent). Another comparable is likely Facebook (up 13.4 percent in October).
Does this mean Snapchat was really worth 14.65 percent more at the end of October than at the beginning? No, it’s just that, well, Fidelity’s Fair Value Committee had to come up with a number. It doesn’t have to be the right number, but it does have to be defensible. It’s like Malkiel said: stock valuation is an “ephemeral process.” Stock market prices may be wrong, but they’re at least real.
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